OSC blasts Ernst & Young over shoddy audit of Zungui Haixi IPO

Ontario Securities regulator blasts global auditor over work for collapsed Chinese firm.

Advisors should be cautious when reviewing prospectuses, as even the Big Four auditors are not immune from mistakes, and potentially egregious ones if the charges laid by the Ontario Securities Commission against Ernst & Young (E&Y) are accurate.

OSC has issued a scathing rebuke of E&Y, saying the auditor failed to meet proper standards in its pre- and post-IPO audits of Chinese shoemaker Zungui Haixi Corp, which was delisted from the Toronto Exchange in 2012.

In a statement to WealthProfessional.ca, E&Y said "we will vigorously defend against the OSC's allegations." 

In its report, the OSC said that it found that E&Y failed to conduct the IPO audit in accordance with Canadian generally accepted auditing standards (GAAS) and relied on certain audit results that raised more questions than they answered.

The OSC said During the course of its audit E&Y identified a risk that Zungui could use fictitious distributors to fraudulently inflate its revenue, but the auditor disregarded evidence suggesting that the company had grossly exaggerated its sales to purported distributors.

The regulator said E&Y also failed to treat multiple red flags about the company’s revenue and earnings with appropriate skepticism and failed to conduct a sufficient review of the audit evidence, leaving the review of key evidence in the hands of a staff member with limited experience.  

In February 2012, the OSC found Zungui liable for multiple violations of Ontario securities law, including a failure to file audited annual financial statements. It also found the remaining directors liable for multiple violations. In August the company was permanently cease-traded.

The IPO Audit was a higher risk audit, said the OSC, as it was conducted in preparation for a public listing, involved a foreign-based entity, and identified a risk of fictitious distributors and suppliers.

The OSC says E&Y’s manager for the audit, who was the sole reviewer of significant portions of the working papers, was a new employee who had never conducted an audit of a China-based company and had never conducted an audit with E&Y before. Although the audit evidence included many Chinese-language documents, other than the partner, no member of the audit team senior to the manager could understand Chinese.

Although a series of fraud risks had been identified for the IPO Audit, no member of the audit team senior to the Manager had reviewed the work performed to address the fraud risks, the OSC alleges.

Ernst & Young issued a statement in response to the charges: “We will vigorously defend against the OSC's allegations. Issues concerning Zungui Haixi came to light as a result of actions we took during our 2011 audit. We brought these issues to the attention of the audit committee and management, and eventually resigned as auditor. We have cooperated with the OSC throughout its subsequent investigation.”

The auditor said that the OSC’s statement of allegations, “by its nature, is designed to present one side of events, and not the whole picture. The evidence will show that the OSC allegations do not fully describe all of Ernst & Young's audit work, which met all professional standards.”

E&Y previously found itself in hot water Sino-Forest Corp, a Mississauga-headquartered Chinese timber firm that collapsed amid allegations it was a multibillion-dollar fraud.